Automated Market Makers (AMMs) have become central to the functioning of liquidity across networks like Stellar. One of the most important aspects of AMM-based trading is understanding how price impact and slippage affect trades and liquidity pool performance. This post explores how these dynamics work, why they matter, and how they influence returns for liquidity providers.
How AMMs Work: The Constant Product Formula
At the core of AMMs is a simple but powerful formula:
x × y = k
Where x and y are the reserves of two assets in the pool, and k is a constant.
Every trade with the pool modifies the reserves in a way that keeps the product of their quantities equal to the constant k. This design ensures that the pool can always offer a price for both assets, adjusting automatically based on supply and demand. For example, if a user wants to withdraw one token, they must deposit more of the other token to restore the balance defined by the constant product.
An Example of the Formula in Action
Imagine a liquidity pool contains 1,000 XLM and 100 USD, resulting in k = 100,000. If a trader wishes to buy 10 USD from the pool, the USD reserve drops to 90. To maintain k, the XLM reserve must increase to approximately 1,111.11. This means the trader must supply 111.11 XLM to receive 10 USD.
This change illustrates a core feature of AMM pricing: the more one withdraws from the pool, the greater the cost per unit becomes. This effect is what we refer to as price impact.
Defining Price Impact and Slippage
Price impact refers to the change in an asset’s price within the pool as a direct result of the trade size. Because AMM pricing is governed by the constant product formula, large trades cause disproportionately larger shifts in price. The deeper the pool, the greater its liquidity, the smaller this impact will be for any given trade.
The formula to estimate price impact is:
Price Impact = (Δx / x) × 100%
Where:
- Δx is the trade size
- x is the current reserve of the input token
Slippage is the difference between the expected price and the actual price received due to this impact. Traders, especially those dealing with large orders or low-liquidity pools, often experience slippage as a hidden cost.
The Role of Pool Size
Deeper liquidity pools can absorb larger trades with minimal price disruption. In contrast, shallower pools are more sensitive to changes, leading to greater slippage and volatility. This relationship is non-linear, meaning doubling the liquidity more than halves the price impact.
Understanding this principle helps liquidity providers and traders make informed decisions. Smaller pools may yield higher returns due to more frequent and volatile trading, but they also carry greater risk for both sides of a transaction.
Pool Fees and Returns
In Stellar AMMs, every trade includes a 0.30% fee. These fees accumulate in the pool and serve as the primary reward mechanism for liquidity providers. Over time, they increase the value of each provider’s share in the pool.
To evaluate pool performance, it helps to focus on a few key metrics:
- Weekly Return:
(Weekly Earnings / Total Reserves) × 100 - Volume Ratio (weekly volume relative to reserves):
(Weekly Volume / Total Reserves) × 100 - Annualized Return (projected from weekly return):
(1 + Weekly Return)^52 - 1
Higher volume relative to reserves generally indicates better capital efficiency, especially when paired with consistent fee accumulation.
Connected Pool Dynamics
Liquidity pools don’t operate in isolation. When several pools share a common token, price changes in one pool can ripple through the others. Arbitrage traders exploit these price differences, helping to realign prices across all connected pools.
However, the depth of each pool determines how much volatility is transferred. A change in a large pool can trigger amplified shifts in smaller pools, especially if the smaller ones have limited reserves. This interconnectedness makes systemic liquidity distribution an important factor in volatility management and price stability.
Optimal Liquidity Conditions
Successful liquidity pools tend to share a few defining characteristics:
- Balanced token ratios: Preventing one-sided dominance
- High trading volume relative to reserves: Indicating active usage
- Clear trading routes: Minimizing competition and fragmentation
- Right-sized liquidity: Offering enough depth for stability, but not so much that capital becomes inefficient
These conditions improve returns while reducing unnecessary slippage and impermanent loss.
Risk Factors in Liquidity Provision
While AMMs offer passive income opportunities, they also come with specific risks:
- Impermanent Loss: Occurs when prices diverge significantly between paired assets
- Smart Contract Risk: Vulnerabilities within the protocol code
- Market Risk: Overall volatility in asset prices
- Liquidity Risk: Difficulty exiting positions during market shifts
Providers should always weigh these risks against projected returns and maintain a diversified position across pools and assets.
Final Thoughts for Liquidity Providers
To maximize returns while managing risk, consider the following:
- Monitor performance metrics regularly
- Understand how pool size affects slippage and earnings
- Select pools with a favorable volume-to-reserve ratio
- Diversify across assets and pool types
- Reinvest or withdraw fees strategically based on market conditions
Understanding the relationship between price impact, slippage, and liquidity depth is crucial for anyone interacting with AMM-based systems. Whether you’re a trader or a liquidity provider, recognizing how these mechanisms function allows for smarter decisions and better outcomes.
Liquidity on Stellar | AMMs Explained
